Quest Software, Inc. F4Q08 Earnings Call Transcript

Quest Software, Inc. (QSFT)

F4Q08 Earnings Call

February 10, 2009 5:00 pm ET

Executives

Stephen Wyman - Assistant Treasurer

Vincent C. Smith - CEO

Scott J. Davidson - CFO

Douglas F. Garn - President, Chief Executive Officer & Director

Analysts

Phil Winslow - Credit Suisse

John Difucci (John Hafner for John Difucci) - JP Morgan

Abhai Lamba - UBS

Walter Pritchard - SG Cowen and Company

Richard Sherman - MKM Partners

Derek Bingham - Goldman Sachs

Mark Murphy (Brian Schwartz in for Mark Murphy) - Piper Jaffray

Tim Klasell (Darlene Dyer for Tim Klasell) - Thomas Weisel Partners

Rob Owens - Pacific Crest Securities

Presentation

Operator

Good day, everyone, and welcome to the Quest Software fourth quarter earnings release conference call. Today’s conference is being recorded. With us today are Vinnie Smith, Executive Chairman, Doug Garn, Chief Executive Officer, and Scott Davidson, Chief Financial Officer.

At this time I’d like to turn the conference over to Stephen Wyman, Assistant Treasurer. Please go ahead sir.

Stephen Wyman

Welcome everyone to Quest Software’s fourth quarter call. Naturally we’re thrilled today to have Vinnie Smith, Executive Chairman, Doug Garn, President and CEO, and Scott Davidson, CFO, on the call today. Doug, Vinnie, and Scott will give some thoughts on the quarter and year that ended December 31, 2008 and then of course we’ll have some Q&A.

The call is being webcast from our investor relations website and you can get a copy of our press release issued just a short while ago on this website as well. A replay of this call can be available on this site or using the instructions in our release.

Let me turn quickly to our safe harbor statement. Some of the statements we make today may be considered forward-looking including statements regarding our anticipated revenue and operating markets in future periods and other statements about our plans, prospects and strategies. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please also note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.

Please refer to our SEC filings, including our annual report on Form 10K for the year ending December 31, 2007, our first, second, and third quarter 2008 reports on Form 10-Q as well as our Q4 earnings release for more detailed descriptions of the risk factors that may affect our results. Copies of these documents can be obtained from the SEC at SEC.gov or by visiting the investor relations section of our website.

Also please note that certain of these financial measures were used on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude various charges, including the active tax effects of amortization of intangibles assets acquired with business combinations, share based compensation expense, expenses associated with our stock option investigation, impairment charges related to certain cost method investments, and write-off of acquired in process research and development.

We report our GAAP results as well as provide a GAAP to non-GAAP reconciliation in our earnings press release, a copy of which is available on the Investor Relations area of our website at Quest.com. With that, I’ll turn the call over to Doug.

Douglas Garn

Thanks, Stephen. Let me begin with comments about the full year 2008.

First, I would like to thank our customers and our employees for enabling Quest to achieve record operating results in fiscal 2008. The demand environment is tough and likely to get tougher through 2009, yet our sales activity levels remain healthy and the day-to-day tone of our business seems normal.

As you know, we are an execution-oriented company and management team. I can tell you we are very focused on continuing to deliver solid financial and operating results.

For the full-year 2008, total revenues increased 19% year-over-year to a record $735 million.

License revenues increased 8% to $34 million on an as reported basis. We experienced a one-time benefit to license revenue in Q107 from a change in accounting policy normalizing 2007 license revenues to include that benefit, license revenue growth in all of 2008 was 13%.

Service revenues increased 24.5% in fiscal 2008 to a record $401 million. Maintenance revenue growth of 26% was the primary driver of increased service revenues.

Vinnie and Scott will speak more to operating margins and cash flow, but I wanted to emphasize that we managed expenses tightly all year.

In Q2, we saw the economy weakening and implemented significant cost cutting measures, including a reduction in force. We did the same to a lesser extent in Q4. We have completed a thorough budgeting process for 2009 with detailed resource allocation decisions. Although most areas of our company are operating with flat or down budgets in 2009, we are continuing to invest in high growth areas such as virtualization. Almost halfway into Q1, we are down around 2% in headcount versus yearend. This contrast, by the way, sharply with our normal pattern of heavy hiring in the last and first quarter of a year.

Now let’s cover the fourth quarter results. Total revenues increased 8% year-over-year in Q4 to $201 million. A new record for Quest and our first quarter ever where we’ve exceeded the $200 million threshold. The exchange rates, particularly the weaker British pound, materially affected our operating results in the quarter. On a constant currency basis, the fourth quarter total revenue growth was 12%.

License revenues were down year-over-year by 6%, but increased 1% on a constant currency basis as well.

Total license bookings were below our initial planning numbers for the quarter. We were nonetheless pleased to deliver slight growth on a constant currency basis over strong license revenues in Q407.

Service revenues, which are primarily software maintenance and support piece had another strong quarter with 24% growth year-over-year. Exchange rate fluctuations did not materially affect our Q4 maintenance revenues. Service revenues comprised 52% of total revenues in the quarter. We believe our maintenance renewal rates are holding firm despite economic pressures and Quest continues to enjoy a high level of customer satisfaction with our product support services.

We have invested our renewal capabilities and systems over the last several years and believe this is paying off for Quest and our customers.

Our operating income and margins exceeded our guidance and external expectations. With pro forma operating margins coming in at 18.5% for the quarter. We achieved this through strong cost containments throughout the year. We also substantially completed our integration of the NetPro acquisition in Q4 and this went as well as any acquisition integration I’ve seen at Quest. NetPro exceeded our revenue expectations and margin expectations for Q4 and believe these products will perform quite well in 2009.

Now let’s go to some regional highlights. The mix of revenues between North America operations and the rest of world remained about the same between Q407 and Q408. At 61% for NA and 39% for rest of world.

The geographical split for the year was 62% NA and 38% rest of world.

In Q4, both our Australian and North American public sector regions showed solid growth year-over-year. North American commercial and our EMEA operations overall had a tougher Q4. EMEA was certainly hurt largely by the strengthening dollar. It still had a slight year-over-year decline.

We definitely experienced weakness in the financial vertical, yet it was still 13% of our top 35.

Our North American public sector has delivered solid growth consistently over the last several years and was a bright spot again in Q4 and for the full year 2008.

Central Europe and Australia were both equally as strong for the year. Business was more difficult later in the fiscal in the North American Commercial and the U.K., yet we still did see growth in both of those regions for the year.

Now let’s move to deal data, information about our deals. In Q4, we did 219 deals over $100,000 compared to 232 deals in Q407, which is a 6% decrease. We had five deals over a million dollars in Q408 versus four in 2007.

The average deal size for all deals over $100,000 was $257,000 as compared to $225,000 in Q4 of last year.

The percent of international entities contributing $100,000 deals declined as well 6% year-over-year.

Now let’s move away from some of the financial aspects and move toward our products and our markets. I do want to talk briefly about our products and our go-to-market structures. We made some significant organizational changes about 18 months ago. We have general managers within the business now who truly act as CEOs of their unique business. Their jobs are to maximize internal as well as external investments. They drive acquisitions, they drive product strategy, and they drive product messaging throughout their individual product lines. They also work closely with our newly striked sales force, which we have aligned more closely with each one of these organizations. These general managers are measured by how well they capture market share, manage customer deployments, and customer satisfaction. These individuals must feel and read the markets in which they’re in tune with and be aligned closely with our sales organization. The reason I’m bring this up, this was a change that we did make and both Vinnie and I and Scott feel strongly that these changes have clearly aligned us and made us a much more aware and in tune team and the results are truly beginning to pay off as we enter into 2009.

Now I want to go through each one of our product areas within Quest and start with the database.

Q4 showed a continuation of Quest strength in the database tools market. The TOD business closed several $500,000 deals in Q4, including one deal valued at $1.5 million. This clearly demonstrates TOD’s value in larger accounts faced with work of productivity challenge brought on by the difficult economy.

The other thing we experienced with TOD was our freeware version went through the roof as the number of downloads more than doubled in Q4.

Our SQL server business unit has gained critical mass over the last several years.

We believe we are the leading ISV for SQL server. To support our customers, recently we launched a new community site, SQLserverpedia.com. This site provides free information and training for our SQL server customers.

In FY08, SQL server saw moderate growth across all geographies with the strongest performance coming from North American public sector team and Europe. SQL server performance monitoring tools showed strong growth as well, which is continuing to confirm that the SQL servers changing role to becoming more mission critical system in data centers today.

Now let me talk about application management, which primarily refers to our Foglight business.

I’m going to refer to a few wins that we were fortunate to have in Q4. In the Americas, there was a company Worldwide Innovative Consumer Technology Company that does a lot of sales of music over the internet. They chose Foglight to track and manage every customer transaction on their e-store. The strength of our monitoring plus our analytical focus was why we won.

A major petroleum company in Central America has expanded their Foglight investment to manage their entire production database environment plus cover service levels and technical root cause analysis for the end user, the application, the database, and the infrastructure.

In Europe and Asia Pacific, one of the largest European-based airlines selected Foglight to manage their online flight reservation systems and supporting back office systems. Our strong java application management and ability to integrate with other monitoring systems was key.

One of the largest banks in Singapore purchased Foglight for end-to-end management of their online banking service. We provided a single solution to manage critical online banking apps that spans Websphere Oracle database and AIX.

Overall, our monitoring business fell short of internal expectations. We have spent a lot of cycles over the last three months on our application management business and concluded it would benefit from a dedicated field sales focus. Foglight is an excellent product, but needs skilled personnel for its sale and implementation. This year we are striking and focusing our sales force specific to the application business unit. This will allow for subject matter expertise at a rep level with only a handful of products to sell as compared to traditionally many products to sell.

I can tell you we have very high hopes for the application business team and its increased focus for 2009.

Now let’s move to Windows management business. Q4 was a very good quarter for the Windows area. All solutions of active directory, identity and access management, unified communications and share point experienced growth. Our Windows management products were strong in the fiscal year as well.

From an AV and identity access management perspective, we were first to market with a comprehensive single sign-on solution for thick and thin client users of SAP. During the quarter, we landed a million dollar plus deal in Switzerland for 135 licenses of this solution.

We also completed the successful integration of the NetPro organization, its people, its products, and events. It is important to highlight that NetPro had a extremely positive impact on the quarter by exceeding the revenue targets we had for it and it also achieved all internal expectations from an expense perspective as well. We closed the deal in Q4 with a major financial institution that was valued at more than a million dollars and included joint products from both Quest and NetPro.

Our sales and technical resources from both companies have set aside past rivalries and working together closely to close this deal and many others as well. It’s really actually been a great testimony to how well these two teams have come together.

Now let’s move to our unified communications group or the exchange group. The market for exchange upgrades and conversions from Notes to Exchange remain strong. Exchange upgrades are being driven by industry consolidations, M&A activity, and divestures across multiple industry verticals. As a result, this led to a very strong Q4 for our migration business.

Customers as well are starting to talk about hosted e-mail as a way to reduce infrastructure and IT cost. To that end, we built support for migrating customers from competitive platforms like Notes or Groupwise into our tools so customers can migrate to Microsoft’s business productivity online sweep.

We’re seeing widespread adoption of Microsoft Office communication server 2007. 2008 was a year of investment for our business in this area. We acquired Akonix systems, which provide compliance and policy enforcement for OCS and other platforms.

Q4 was solid in these areas of unified communications. We’ve had a very good quarter here.

FY08 for both areas combined, we closed seven deals over a million dollars, four in NA and three in Europe.

Now let’s move to share point. This market continues to widely deploy Microsoft Office share point server 2007. It’s become a very competitive market where there is a whole host of smaller software players that we’re competing with. The great news is that we have created excellent tools for migrating and managing share point environments. This area, we’ve experienced dramatic growth both for the quarter and for the year.

We are very excited as well for some of the plans for 2009 to capture market share in this space, which is critical for the long term.

Now let me move to script logic. If you don’t know, script has become our primary way of reaching the small to medium sized business customer for our Windows management space and the great news is the market remains strong for Quest. Script has very solid transactional Q4, closed many smaller deals, which more than offset some of the softness it experienced in larger transactions.

North America, the U.K., and Germany all were very strong markets for Script in Q4.

I’m going to move to virtualization. On the service side of our virtualization, Vizioncore continues to deliver very strong results. We had record revenue in Q4, despite the economic conditions. We closed out the year of 2008 with over 15,000 clients within Vizioncore, which is absolutely remarkable. Certainly we’re hoping that they more than double that this year. We are seeing great uptake for our V product, which helps monitor the ever growing virtualized environments that we’re seeing out there.

We continue to make substantial investments within Vizioncore and our European and APAC business, as well as within our R&D.

On the desktop side, again we continue to see strong traction on the desktop virtualization area. Customers are highly interested and we’re engaged in many, many positive opportunities. We’ve signed a significant OEM deal with one of the top tier one hardware vendors and it’s a nice size opportunity for us, but cannot give you any more detail.

We received the best of the M World 2008 finalist award for work space and in 2008 we converted close to 700 new customers within the provision side of our business.

Now quickly, some quick comments on 2009, and as you can imagine we are entering a period of time where it is very difficult to anticipate how things will unfold. The good news is our pipelines are very strong and showing great solid growth. Positive results from our sales striking, we’re striking our sales force in all different areas from windows to database to our application Foglight business and really focusing on our key product families.

We’re excited about the new product releases that are coming out, like our new back-up and recovery products for Oracle, which is called light speed for Oracle, that was just released two weeks ago.

We are more focused than ever at making sure we maximize the opportunity that sits ahead of us. We remain extremely committed to our 3,400 employees and our thousands of customers that continue to support Quest.

At this point, I would like to turn it over to Scott to give a little bit more of the financial details.

Scott Davidson

Thanks, Doug. Good afternoon, everyone. So Doug touched on some of the financials. I’ll try to move through it quickly for you.

Overall the Q4 and full year 2008 results, as Doug said, were solid. From a summary perspective, total revenues were $201.6 million, an 8% increase year-over-year. If we look at that on a constant currency basis, it would have been 12%. Total revenues were $735 million, a 17% increase as reported or 16% on a constant currency basis.

Non-GAAP operating income was $52.6 million, which is a 38% increase and $136 million or a 15% increase for the year.

Cash flow from operations was $38 million and $152 million for the full year. Deferred revenue was $339 million, a $53 million increase or 19% over last year. Non-GAAP diluted EPS was $0.37 per share.

We acquired 11.4 million shares of our stock based upon the execution of a tender offer completed in December of 2008. The net reduction to the weighted average shares outstanding was $1.9 million for Q4 and $470,000 for the full year 2008.

The Q4 license revenues decreased 6% year-over-year, but actually up 8% for the full year to $230 million. Service revenue were up 24% for both Q4 and full year to $108.6 million for the quarter and $401.3 million for the year.

Along product line, the licensed revenue was the strongest in our Window Management and the Virtualization Management product areas, which offset declines in application and database management.

Maintenance revenue were driven primarily by the Windows Management products including the benefits from NetPro, which accounted for about 16% of the increase.

Also contributing to the growth in maintenance revenues, but to a lesser extent, were maintenance renewals on the application performance management and virtualization from management products.

The mix for the quarter between license and services was 46% on license side and 54% on the services side. The mix in Q407 was 53% license and 47% services.

From a geographic perspective, NA generated 64% in the quarter and the rest of the world did 36%, whereas Q407 the mix was 62% NA and 38% rest of world.

Moving to expense side, I’d like to remind you that the Q4 and full year 2008 non-GAAP results exclude the after tax of the amortization of intangible assets required with business combinations, share based compensation expenses, expenses associated with the stock option investigation, impairment charges related to certain cost method investments, and write-off of acquired and processed R&D, and the earnings press release gives you that reconciliation between GAAP and the non-GAAP numbers.

Total non-GAAP expenses in the quarter were $149 million, virtually flat from Q407. We managed our expenses closely in the second half of the year and also benefited from strength in the U.S. dollar.

The average headcount for Q4 was actually up 7% and that includes the impact from NetPro. Excluding NetPro, Q4 average headcount was up 3%.

In keeping with the commitment to contain expenses, we carried out additional cost cutting initiatives during the fourth quarter. These measures included workforce reductions across all functions and geographies, totaling 54 heads. This one added to the 148 heads removed during the business in Q2, totaled approximately 6% reduction in headcount for the full year.

We also made further cuts in discretionary items such as travel and marketing in the fourth quarter.

We saw an impact to our expenses from the strength from the U.S. dollar and as a large majority of our software development costs is based offshore, we see expense improvements during U.S. dollar strength.

The total ending headcount at December 31 was approximately 3,500, which is essentially flat from the year ago period, if you exclude NetPro.

Turning in more detail to the expense items, sales and marketing expenses for the quarter were $76.6 million or 38% of total revenue as compared to $79.4 million and 42.5% of the total revenue in the same year ago quarter. In the aggregate, the year-over-year changes primarily related to reduced commissions on lower bookings, reduced discretionary marketing spend, and the benefit from foreign exchange. This is slightly offset from the impact from the NetPro heads.

Research and development expenses in the fourth quarter were $37.5 million or approximately 19% of revenue. This compared to expenses of $33.3 million or 18% of total revenue in the year ago quarter. About half of the increase was related to labor increases, including NetPro, which was partially offset by the benefit of foreign exchange.

General and administrative expenses were $17.6 million or approximately 9% of total revenue as compared to $19.1 million, which was about 10% of total revenue in Q4 last year. The reduction in G&A was related to broad base reductions in both labor and consulting.

Looking at income, GAAP operating margins were $19.7 in the quarter and GAAP operating income was $39.6 million. Non-GAAP operating income was $52.6 million during the quarter, generating an operating margin of 26.1%. Non-GAAP operating margin in the full year was 18.5%, which is the top end of our guidance range as we benefited from headcount reductions, strict cost containment measures, such as travel reductions, foreign currency impact, and the fact that we made NetPro an accretive deal one quarter ahead of schedule as Doug mentioned.

Other income expense net in the quarter was a net expense of $1.4 million versus a positive $4.2 million in Q407. OI&E was $3 million for the full year 2008 versus $22.4 million in full year 2007.

The primary drive of year-over-year change in OI&E was related to the strength of the US dollar and the lower reinvestment rates in our investment portfolio.

The GAAP effective tax rate for 2008 was approximately 18% compared to 30% in the prior year.

The comparative difference is the result of several factors including the projected mix of income between geographies, the closure of the IRS examination of prior period tax returns that resulted in the reduction of the affected tax during 2008 and the booking of a valuation allowance in certain jurisdictions that resulted in an increase of the rate in 2007.

So the annual non-GAAP tax rate was 23.8% compared to 32.2% in 2007, approximately an 8% reduction. The reduction was primarily due to the mix of pre-tax income and the impact of the IRS adjustment mentioned previously.

I’d say for 2009, we should be probably be thinking about high 20’s non-GAAP tax rate on a go-forward basis.

The GAAP net income for the quarter was $20 million and GAAP EPS was $0.28. Non-GAAP net income was $39.3 million and non-GAAP diluted EPS was $0.37. Fully diluted weighted average shares outstanding was approximately 105 million shares.

Now turning to the cash flow statement and the balance sheet. As of September 31, cash and investment were $260 million. That’s after the effect of the $143 million spent for the stock buyback in early December.

CapEx for the quarter were $4.4 million. Cash flow from operations was $38 million in the quarter compared to $42 million in Q407 and the DSOs was 71 days which was a four day improvement over the 75 days in Q407.

Deferred revenues increased 19% to $339 million up $53.4 million year-over-year. 13% of that increase was related to the NetPro acquisition.

At this point, we would normally turn to provided view for 2009; however, given the lack of visibility regarding the economy and therefore on our own business, we’re not going to provide guidance at this time. Simply put, entering 2009, the range of potential outcomes for revenue seems overly broad.

With regard to expenses in 2008, we ran the business tightly and delivered margin improvements by managing down the expense structure, even as the economic environment continued to deteriorate. Since approximately 75% of our total expenses are headcount driven, our intention is to maintain this disciplined approach as we did in 2008 for managing expenses in 2009.

So let me turn it over to Vinnie and he’ll give you some of the outlook on our markets for 2009.

Vincent Smith

Thanks, Scott. I’m just going to take a moment and share with you a couple facts and we share these thoughts amongst management team.

First of all, we have a strong company. We execute well, we’re very capable of running a business in software space, and that is reflective of the numbers we have when we start talking customers.

We’ve been in the database business the longest and we have over a million users using one very broad product every day in their job and we have tens of thousands of customers in the database area running our products for mission critical solutions.

So we have a unique position in that market place. We’ve sold well and people appreciate our solutions. They run them in the most mission critical environment in the entire world and we’re in a unique spot. Same goes for windows, we estimate that we’re up over $45 million seats being managed by us on our active directory products and over $30 million in the exchange world. Tens of thousands of customers on point products for the enterprise, puts us in an unbelievable position. We’re worked hard to gain these market share positions. We’re achieved a lot of revenues and a lot of profits, but we’ve serviced these customers really well.

The third market, the application/virtualization. I’m starting to think about that as a blended market because the products are becoming so intertwined. We’ve got an enviable and awesome position in that new market for us. So the reason I share some of these stats for you is to let you appreciate that we can operate and execute well once we’re in a market and we’ve done that and so we have large install bases, which really give us the opportunity to serve these customers and that’s a big deal, because we make all our profits by the continued relationship with the customer. The longer we serve them, the more money and more profitable our relationship becomes for both them and for us.

And so, we’re doing a lot of surveying inside our business and a couple things are coming through the survey work. One is we stand out as a very trustworthy vendor, which in these times they’re going to be squishing every cost they can and trying to hold back on any purchase of either product or maintenance or renewal is going to be a characteristic that you’re going to need to have.

So we have proven to them that we provide value, we do what we say we’re going to do and we stand out relative to other vendors as being very trustworthy.

The other thing we’re going to focus on is satisfaction. We’re watching our support satisfaction rates grow, which we’re always in the high to mid-80’s break through 90, with us trying to deliver enough service that maybe some day we can achieve 95% satisfaction among our supported customers. Right now, we’re at 92%.

Another indication of satisfaction is our renewal rates on some of our key products are up over 90% and on the whole in the high 80’s and that’s significant, because there’s a piece of our business in the migration business where people tend not by support at all. So when your average is in the high 80’s and people buy virtually zero in some of your products, you know you’re got a remarkable situation where people are deploying your products, getting good value, and sending you a check every year.

So the net of this is we’ve got a good operating company that’s got a proven install base that we have serviced well. With that, when I think about the different legs of this stool that generate these businesses and create the revenues and profit, we have a business in the database area that’s growing slower, but there’s still a lot of innovation to be brought to market and we just brought a really cool new product, for instance, in the Oracle market place.

So hopefully we’re going to sell a lot and continue to maintain some level of growth in that database market. In the windows market, we believe we are about 25% penetrated with the products we have in market. That means that we have a lot more market to sell to and we have a lot more products to continue to innovate and bring to market. That business is now bigger than the database business and it can continue to grow and potentially double over the next couple years, five, six years. It’s not growing as fast as it once would, because when you’re growing a $50 million business to $100 million, it’s a lot easier than growing a $300 or $400 million business to $600 or $800 million dollars, but it’s a really cool opportunity to have this many customers. We have a lot more product to sell with our current products, but then to have the opportunity to innovate to bring more product to the market.

On the virtualization side, we’ve got a great foothold in a new market and we’ve got an opportunity to become a major provider of big time value for those customers.

We have 3,500 people in this company. We’re a very strong company with wonderful people. We’ve got a good plan going into 09. I’m more confident in our operating plan this year than I’ve been in almost any year. We are focused on how we go to market and how effective we go to market, what products are going to work, and so the only uncertainty is what’s the buying climate going to be? What’s the macro buying climate going to be like?

And so, we step into this situation carefully. We’ve got a good prior history. We’ve got a great group of managers, a great group of employees, and we have a very uncertain market situation. Cool news is, our renewal rates are really high so we know that there’s going to be a lot of revenue that comes on that side.

And so, we saw this situation in Q4. We saw a very difficult climate. We know that we missed, we didn’t miss any numbers, what I’m trying to say, but there would have been a fair amount, substantially more revenue coming in if the climate hadn’t changed the way it did. And so, we expect Q1, Q2, Q3 to be relatively difficult comps, because the banking meltdown and all the repercussions from it really didn’t show up in our world until Q4.

So we roll into this year with some comps on Q1 and Q2 and Q3. For me, it’s like we’re as prepared as we can be. We’ve got a great group of people. We’ve got a great group of customers. We’re serviced them well. And so, I’m actually pretty fired up about what’s going to happen in 2009. We’re going to go get more customers. We’re going to service them better. The only thing we don’t know is licensing coming in, but I think we’re not alone. Every other company in the universe is experiencing the same level of uncertainly, but I am truly excited walking into this year with the preparation and situation we face and we’ve got to go out now and go do it and see what it’s going to be like.

So with that, let me open it up to question-and-answers for Scott, me, and Doug.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go first to Phil Winslow – Credit Suisse.

Phil Winslow - Credit Suisse

When you look at headcount over the course of this year, how do you expect that to trend first half and then over the full year and also if you could give us a feel for expenses too.

Scott Davidson

I think what we are comfortable saying is that we managed headcount pretty aggressively in 2008. We made the cuts where we had the opportunity. In certain businesses right now, like in our virtualization business, we’re making incremental hires. In other areas, where we’re growing. In other parts of our business that are not growing, we’re sort of cutting.

I think I can say that we’re not trying to incrementally add many heads at all. Unless they’re absolute critical replacements, we’re trying to keep it as flat as possible but make those critical investments where needed.

From an expense perspective, you’ve got the run rate of Q4 in expenses and knowing that a portion of that is tied to commission expense based on the bookings numbers. You should be able to take that and get an idea what the run rate for Q1 would be if you sort of back that down a little bit.

Operator

Next John Difucci (John Hafner for John Difucci) - JP Morgan

John Difucci (John Hafner for John Difucci) - JP Morgan

Looking at the operating margins this quarter, they were really healthy and pretty strong when you look at year-over-year and sequentially. Scott talked about how it provided a benefit. Can you quantify a little further how much of a benefit you saw from FX to operating margins this quarter?

Scott Davidson

Actually the revenue line was hurt by about $8 million from FX in Q4 and the expense line was benefited $7 million during the quarter. So net-net it was fairly neutral within a quarter, but $7 million specifically for the quarter.

John Difucci (John Hafner for John Difucci) - JP Morgan

Do you guys hedge your net exposure at all?

Scott Davidson

We do not.

Operator

We’ll go next to Abhai Lamba with UBS.

Abhai Lamba - UBS

Margins, I assume that revenue you have lack of visibility, but on managing your expenses, solving for flat margins next year or solving for margin expansion?

Vincent Smith

What we’re solving for is how much to spend right now and as Scott indicated we’re looking for a pretty flat spend. With regards to margins, we have a revenue target that we’re not giving guidance to and so until the revenue start coming in, we don’t know what the margin should be. We know what we achieved in margins last year, but we’re not saying hey we have to achieve that next year, but we’re sensitive to it. We’re not like saying that doesn’t matter. We appreciate the benefit of bringing an increase in the margin as we did last year, but we’re just not certain what’s going to go on the revenue side to be then articulating out positional margins right now.

Operator

We’ll go next to Walter Pritchard - Cowen and Company

Walter Pritchard - Cowen and Company

Just a couple number questions, could you give us a share count. I know your share count came down sort of post this quarter from the buyback. Could you just give us a level that we should look at shares to be in Q1 and build off it from there?

Scott Davidson

Not withstanding any future buybacks that are in place right now. I think you’re going to see a little bit of a creep. We finished the year with about $1.9 million less or about $105 million outstanding. The impact, you know, the way the weighted average shares calc works, because we completed the buyback I think it was the first week of December actually. It’s the weighted average shares for that number of the quarter. So we only got the benefit of about roughly 20 of the 90 days in the quarter of that weighted average share count.

So I think it’ll be kind of flat. It may creep up just a million or so each quarter.

Walter Pritchard - Cowen and Company

If you only got 20 days of the buyback in the December quarter, you should see a step down in Q1.

Scott Davidson

It should step a little bit down in Q1 and then sort of incrementally start stepping back up from there. That’s correct.

Walter Pritchard - Cowen and Company

Scott, I know you’re not giving guidance. Typically on the seasonality side, your licensing is up and down 20% or so sequentially into Q1. I mean should we assume sort of that or worse this quarter just given the environment?

Scott Davidson

It’s hard to answer that one without providing guidance, Walter, so I’m going to have to say I’m going to have to pass. As I said in my prepared remarks, there’s a range of outcomes that could suggest something, you know, the history that we’ve seen is not necessarily a predictor of what we’re living with right now. So that’s why we’ve decided not to really comment on that.

Walter Pritchard - Cowen and Company

Vinnie, on the M&A side, so I guess we’re probably getting into territory here where the evaluations even on the private side should be starting to get re-said and you guys historically sort of sat on cash during times when evaluations are high. I’m just wondering how we should think about your use of the cash now that evaluations have come down, but you have shown an interest in buying your own stock as well. What should we think about that from a 2009 perspective?

Vincent Smith

My thinking is there’s going to be opportunities on both sides. I wish there was more healthy software companies for us to look through that we could possibly merge with or acquire, but the list is pretty short and so but we do see a fair amount of small private ones that are out there that are really struggling to get by. So we think that there’s going to be opportunities on the acquisition side for us to use cash or stock and we also think that we like the result we got with the stock buyback. It was very much over subscribed, so we appreciate that there’s a fair amount of people who wouldn’t mind creating a liquidity if they could and so we’re sensitive to that as well.

We were listening when we did the last buyback, the shareholders who said we would really like you to perform in this area. We’re still getting some of that pressure to buyback some shares. So that’s definitely going to be a topic for us to look to use the cash to either buyback shares or to make acquisitions, but we’re not going to just go out and start buying companies because they’re cheap. We’re going to try to have some discipline and really use this opportunity to broaden our technical reach where it makes sense.

Walter Pritchard - Cowen and Company

Scott, just on the math there on the buyback, just having some trouble. You did take out about 11 million shares I think in the tender. Share count went from 107 in September, it seems like it would have at least hit bottom somewhere on the order of $10 or $11 million down from there. Could you explain that better?

Scott Davidson

You’re not getting credit for the whole $11 million in the calculation of the buyback. It’s the weighted average number of shares. So for two and a half months of the three months during the quarter, you still had the full $107 million or whatever it was that was out.

Walter Pritchard - Cowen and Company

But March you’ll get it. Right? March, you should get that.

Scott Davidson

In the March quarter. Yes. The March number should be a million, maybe two.

Operator

We’ll go next to Richard Sherman - MKM Partners

Richard Sherman - MKM Partners

How much of your cash is offshore versus onshore now?

Scott Davidson

I’d say probably about 60% of it is offshore, that includes Canada as well.

Richard Sherman – MKM Partners

61% fourth quarter number from N.A. I heard a 64% number. Which was the number?

Scott Davidson

So from N.A., it was 64%. 36% for rest of world. Last year Q4 was 62% N.A.

Operator

We’ll go next to Derek Bingham - Goldman Sachs.

Derek Bingham - Goldman Sachs

Scott, question on you talked a little about around the tender offer about potentially looking at the debt market at some point. I’m sure it’s still not right the time, but we have seen some very early signs of thawing. Is that still something that you’re considering maybe in the intermediate term?

Scott Davidson

We’ve actually made considerable progress on the debt side and so I’ll tell you to stay tuned there. One of the things that we’ve seen probably in the last three months is things have thawed considerably while initially we were looking for close to $300 million dollars. We’ve scaled that back a little bit, but we’ve had success in that area and I think if you stay tuned in the short near future, we’ll have some information to bring forth on that.

Now the question will be what if anything do we do with that and what the construct is and we’ll talk about that later, but you are correct. Things have gotten better.

Derek Bingham - Goldman Sachs

Your channel business, I was just wondering if you could give a little bit more color on that in terms of what you’re pushing through that channel. If anything has changed in terms of additional products or introducing a channel. Maybe what percentage of your business that is and where you see it going?

Vincent Smith

First of all, when you look at the Vizioncore business, all of its revenue goes through a channel and will continue to do so. Our Script business, which again is our focused SMB business, basically all of it as well goes through a channel. We recently in this past year made a tremendous commitment within our windows business to begin to adopt a favorable channel approach where much of our revenue now in our Columbus sales organization, which really is our reps selling to 15,000 users and below type of accounts. Virtually all of that revenue, much of it, probably 85% of it, is going through some form of distribution. And then, when you look at our Quest commercial side, it’s running in the mid to high 40’s as far as it’s going through various forms of partners.

From a regional point of view, if you were to look at our European business as compared to our North American business, Europe has had a much stronger partner strategy over the years and it’s getting much richer. Our distribution model in Europe, which is selling in the markets that we don’t have a presence, last year it grew but not the level we want. We made some changes there and we’re actually seeing some good positive results, but I can tell you when you’re not adding a lot of new sales heads if any, one of the areas you’ve got to continue to hope that you’re going to get a lot of growth out of is out of your partners and that’s where we put a ton of effort and you’re going to see it this next year.

Operator

Our next question comes from Mark Murphy - Piper Jaffray.

Mark Murphy (Brian Schwartz in for Mark Murphy) - Piper Jaffray

Scott, quick housekeeping question for you and then a follow-up for Doug and Vinnie. Do you happen to have the revenue contribution from NetPro in the quarter? You said they exceeded expectations, and I guess that compares to $1.4 million last quarter.

Scott Davidson

I’ll give you that. Walter, I’m sure you’re still on the line. I misspoke on the share count thing. I sort of got an update on that by somebody on my team while I’m sitting here. It should be sort of closer down to the high 90’s, basically close to 100 in Q1. So if you’re still on the line, that should be the share count number. I misspoke on that. I apologize.

The NetPro number for the quarter was about $6 million.

Mark Murphy (Brian Schwartz in for Mark Murphy) - Piper Jaffray

Thank you. Then just a follow up either for Vinnie or Doug, we’re all trying here to get our hands around really what is the demand environment for next year. I was wondering if either of you could maybe comment qualitative what you’re hearing from some of your larger customers regarding their IT budgets for this upcoming year. Thank you.

Vincent Smith

I think what we’re hearing is I would think is consistent with others. I actually haven’t heard what others have said, but I can tell you what my people are telling me is that in many accounts budgets are still somewhat fluid. A lot of them are not decided at this point. I mean we did get a little bit of budget spend there the end of Q4 that was nice that in the last few days it drove the number up a bit higher than what we expected.

We are not seeing the number of accounts where they’re saying our budgets are finalized and here’s how much I have to spend this quarter, which is one of the reasons why you’ve got to have a lot more deals in the pipeline. Our pipeline is going into Q1, which is a real positive or proven to be healthier than they’ve ever been, but we really need more deals to make sure we can capture the opportunities, based on the fact that a lot of the budgets are moving all over.

So we are seeing a lot of customers who are still firming up their budgets and it’s going prove to why we’re a little bit conservative and concerned about what Q1 will look like.

Operator

We’ll go next to Tim Klasell – Thomas Weisel Partners.

Tim Klasell (Darlene Dyer for Tim Klasell) – Thomas Weisel Partners

It sounds like the Foglight business did pretty well in the quarter and some competitors haven’t seen quite as favorable trends. Just wanted to see if you could give us a little bit more color on what’s driving business there and what we can expect going forward.

Vincent Smith

This area where I spent a lot of time, this is Vinnie, we had a good customer account on Foglight, but the revenues were short, because we just couldn’t bring the big deals in. Probably like some of the other customers. We were not able to close in the Foglight area, the number of big deals that we have in the past and we came up from a revenue point of view short. We’re actually doing final customer counts and getting lots of people using the product, which bodes well hopefully for the future.

Just to put a little more color on this question and the question before, I think this is going to be an interesting demand situation, because certain product areas are going to get postponed and others, if you can show a relatively quick return on investment, are going to probably go first.

We saw that in the IT slowdown that we experienced in 02 and 03 where we all got really familiar with what ROI means and the speed of ROI and what our customers needed to see to justify a purchase. I think we’re going to go through another round of that and I think some products are going to suffer more than others and I think in Q4 Foglight paid the price for that, because it’s a longer payback cycle than some of the other stuff.

We just released a product for Oracle where we got our first example where the payback was literally about one hour, because if you install the product you saved that much more money in other purchases that you don’t need to make. And so, those types of products are going to ring home quickly and others have a longer payback cycle are going to be longer and unfortunately Foglight many times is a little bit longer payback cycle.

Operator

We’ll go next to Rob Owens - Pacific Crest Securities

Rob Owens - Pacific Crest Securities

Could you provide a little more breakdown on the services line, specifically what was PSO related in the corner? Second question was around deferred revenue. Just wondering if you could quantify the impact whatsoever, what NetPro was net sequential increase?

Vincent Smith

We’ll have to dig for that. Can we go to next call and come back.

Operator

Actually this is the last question in the queue.

Scott Davidson

On the deferred piece, deferred was up $53 million. 13% of that $53 is related to NetPro. So about $6.9 million increase in deferred related to NetPro. So the PSO piece you pull out.

Rob Owens - Pacific Crest Securities

Okay great. Thanks.

Operator

Having no further questions, I’d like to turn the conference over to Vinnie Smith for any additional or closing comments.

Vincent Smith

I’m going to actually turn it over to Doug to let him conclude.

Douglas Garn

First of all, thank you for taking the time. We were pleased with our Q4 results, even though I think we did experience the slowdown that others did, but we still were able to achieve the targets hoped for. Q1, as we talked about, certainly has the potential to be a spicy quarter.

From a license perspective, we feel very strongly that on the maintenance side we’ll continue to perform with a lot of strength in that area.

Our sales teams, I can promise you, are driving like crazy. There’s actually I think a fair degree of optimism that they could do okay, but as we talked about on budgets and how customers are behaving, it’s far too unpredictable to really make any commitments in that regard, but I do appreciate the fact that our teams out there are working incredibly hard and are very committed to making this a reality and so to all of our people, thank you so much. I can promise you we got about out of our 3,500 people, there’s probably about 3,000 sitting here listening and we truly appreciate all that they’re doing to our shareholders. Thank you so much for taking the time, and our customers, we appreciate greatly what they have continued to commit to us both in buying new products as well as continuing to invest in their existing ones.

So we’re looking forward to this quarter and having some fun and look forward to talking to you guys in another 90 days.

Operator

That does conclude today’s conference. Thank you for your participation. You may now disconnect.

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